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August 29, 2013

Implied Volatility: Lessons From the 2013 Options Market

In last month's Volatility Advisor blog posting, we discussed the impact of equity correlations on option. Since 2008, many sectors’ correlations to the broader market remained at elevated levels. In early 2013, correlations began to deconstruct as fundamentals and demand for yield drove a wedge into those historical relationships.

This month we will dive into specific implied volatilities determined by the options market in an effort to demonstrate the dispersion that volatility traders witnessed in the first half of the year. The options market is a great place to assess the forward-looking estimation of the overall market as well as expectations of underlying sectors and their correlations to the market. When trying to determine value from an options perspective, one must have a sense of historical correlations across various time periods and the propensity for mean-reversion over time.

At the turn of the year, the Fiscal Cliff ‘resolution’ caused option premiums to decline as fear subsided. When the equity market shot out of the gates in January, any covered call investor was short volatility, which in hindsight was much too cheap. Seen in the table below, the option market implied normalized returns of +/- 5% – 10% for the subsequent quarter in most sectors 1 of the economy, as measured by the SPDR ETFs. For example, the S&P 500 implied a one standard deviation move of 8.08% in Q1, yet returned 10.6%, which indicated a probability of occurrence of 9.48%. More surprisingly, the defensive sectors—Health Care, Consumer Staples and Utilities—produced returns that were over two standard deviations wider than expected. The run-up in Consumer Staples was so dramatic that its probability was less than one percent.

In other words, a quarterly return of 14.52% in Staples would occur once out of 142 quarters or once every 36 years! Clearly, it would have been better to be long stock as opposed to writing calls during that period.

During Q2, the implied volatility landscape began to shift. Not only did nearly all implied volatilities narrow relative to Q1, but actual results were drastically different. All sectors, as indicated by their corresponding ETFs, were closer to their implied volatilities than at the close of the first quarter. No single segment of the market exhibited greater than a one standard deviation move prior to expiration in June.

In comparison to Q1, the S&P 500 returned 2.91% during Q2, though the implied option return estimated a +/- 6.26% return. In its simplest form, this differential demonstrates the value of trading volatility, not only in sector ETFs, but also in individual names when realized returns from options come in below that which is implied by call premiums.

The market prognosticators share several views on the reasons for strong market returns in the first six months of the year; however, option writers would point to the relative risk premium that was taken in many leading sectors of the market and admit that it was not worth the premium received. In addition, as sector Betas began to normalize in Q2, volatility traders were able to capture more of the implied volatilities of options written than in Q1. What does this all mean for a volatility strategist? First, it demonstrates the value of diversification across sectors. Second, it portends the need to focus on a consistent process and not attempt to time the path of the markets. Finally, it comes back to understanding that Beta and correlation are long-term and mean-reverting.

The takeaway? Developing a strategy to capitalize on these short-term inefficiencies requires a historical perspective on the nature of sector Betas and implied volatility.

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